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Will Caterpillar's Restructuring Prove to Be a Game Changer?

Are the changes Caterpillar is making enough to significantly improve its financial outlook?

The saying "running fast just to stand still" is perhaps a perfect description of Caterpillar's (NYSE:CAT) current predicament, with the exception of one key aspect: Caterpillar may be running fast, but it is failing to even stand still, thanks to continued falls in sales and profitability, which could cause further share price declines in 2016.

As a result, Caterpillar seems to be moving backward. And while its restructuring will create a leaner and potentially more profitable business, the external environment Caterpillar faces makes it a stock to avoid right now.

In terms of running fast, Caterpillar is making huge changes to its business in one of the biggest restructurings in its 90-year history. This action has been prompted by three consecutive years of falling sales, which, if followed by further declines in 2016, would be the worst top-line performance in its history. Therefore, Caterpillar is attempting to rejuvenate its financial outlook by slashing costs as it seeks to compensate for more sales deterioration.

On the cost-cutting front, Caterpillar intends to cut between 4,000 and 5,000 salaried and management employees by the end of 2016. It also expects to close as many as 20 production facilities in total, and this move has contributed to a spike in restructuring costs for the 2015 financial year. While restructuring charges were due to hit $250 million last year, they will now be around $800 million and are expected to lower annual operating costs by as much as $1.5 billion once fully implemented, with $750 million of that figure expected in 2016.

While such major cost cuts undoubtedly show that Caterpillar has a degree of control over its financial performance, the reality is that the external environment is currently too big an obstacle to overcome. For example, commodity prices have collapsed and are showing little signs of staging a sustained comeback. With Caterpillar relying on energy and transportation (which includes oil and gas sector products) and resources (which includes mining sector products) for 56% of its sales in 2014, oil at less than $30 per barrel and iron ore at 10-year-plus lows mean reduced spending across the entire industry is unlikely to pick up anytime soon. In other words, Caterpillar's customers are restructuring, and this situation makes Caterpillar's restructuring less effective.

Another external problem Caterpillar faces is the stronger dollar. While the U.S. economy is performing relatively well and this is good news for the domestic construction industry, which remains an important part of Caterpillar's sales mix, the benefits of this performance are wiped out by the negative impact of an appreciating currency on exports. As Caterpillar relied on export sales for 28% of its sales in 2014, this situation really hurts. In the coming months, a further appreciation of the dollar, particularly versus the yuan, could hurt Caterpillar's financial performance yet further and lead its restructuring to have even less of an impact.

More worryingly for Caterpillar, though, are the major changes occurring in the Chinese economy. It's in a transitional period whereby consumer demand will become king and capital spending will take second place. In other words, China's consumer boom is only just beginning, but its capital spending boom may be ending. This situation means reduced demand for iron ore and other commodities and, crucially for Caterpillar, less demand for its products. Although it's a painful reality to face, demand from China for commodities may never return to previous levels and could become viewed as an exceptional period in history.

That said, Caterpillar will become a better business post-restructuring. It will be a lot smaller, more efficient, and more nimble. Crucially, the market will also view it differently. While once it was viewed as a bellwether for global economic growth, Caterpillar is likely to become an increasingly niche player within an industry that may not recover to the same level of demand, even over the long term.

Therefore, as well as becoming more efficient, Caterpillar must diversify its product range yet further and rely to an even lesser extent on the resources and energy and transportation sectors. Cost-cutting is a good start, but Caterpillar now needs to switch its attention to product development for its restructuring to be considered a game changer.